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Dividend Policy
(Relevant to Paper II – PBE Management accounting and finance)
Simon S P Lee, The Chinese University of Hong Kong
D
ividend policy is the policy used by a
Bank distributed a $6.30 dividend per share in
company to decide how much it will
2008. If you purchased shares in Hang Seng
pay out to shareholders in dividends. In your
Bank at $87 per share, the company’s dividend
financial accounting course, you learn that
yield was 7.2% ($6.30/$87) which is much
after deducting expense from the revenue, a
higher than the bank deposit rate.
company generates profit. Part of the profit is
kept in the company as retained earnings and
Dividend payout ratio is another important
the other part is distributed as dividends to
indicator:
shareholders. From the share valuation model,
the value of a share depends very much on the
amount of dividend distributed to shareholders.
Dividend payout ratio = Dividend per share ÷ Earnings per share
This ratio indicates how much of the profit is
distributed as dividend to shareholders. The
Dividends are usually distributed in the form of
higher the dividend payout ratio, the more
cash (cash dividends) or share (share dividends
attractive the share is to shareholders.
which are beyond the remit of this article).
When a company distributes a cash dividend,
Dividend payout ratios vary among companies.
it must have sufficient cash to do so. This
The following table shows the dividend payout
creates a cash flow issue. Profit generated may
ratio of some Hong Kong listed companies.
not be in the form of cash. You may verify
this by looking at the cash flow statement of a
Company name
Dividend
payout ratio
for 2007
Hang Seng Bank
66.04%
HSBC
54.55%
China Construction
Bank
68.24%
Cheung Kong Holdings
20.5%
company. A company may have profit of $400
million but the cash only increase by $190
million in a financial year. This is a concern to
the management as insufficient cash may mean
the company is unable to distribute a dividend.
T/Dialogue April 2009
Investors earn returns from their shares
Sun Hung Kai Properties 23%
in the form of capital gains and dividend
Henderson
14.59%
yield. Dividend yield is an important ratio in
Hong Kong Exchange
89.79%
evaluating investment. For example, Hang Seng
Esprit
80.61%
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You may observe that there are drastic
P0 is the current price, D1 is the dividend in
differences between the dividend payout ratios
the coming year, r is the required equity return
in different industries. The banking industry had
and g is the dividend growth rate. If there is no
a higher dividend payout ratio than property
growth in dividend, g=0, and P0 = D1/r. After
developers. This is due to one important
one year P1 = D1/r but D1 = D2. Thus P1 = P2 and
accounting issue. A large proportion of the
there is no growth in the share price.
profit earned by property developers is not cash
in nature, so these companies cannot distribute
In the constant payout ratio situation,
high dividends.
management maintains a fixed percentage
dividend payout ratio. For example, both Esprit
Other factors in addition to profit and cash
and Hong Kong Exchanges and Clearing have
flow may influence the dividend level. In some
indicated that they distribute about 80% and
countries, dividends are taxable. The higher the
90% of their profit respectively as dividends.
dividend, the higher the tax an investor needs
This provides clear direction to investors.
to pay. In such cases, high dividends are not
desirable. If a company is expanding, it needs
In a residual dividend policy, profits are used to
to keep sufficient cash for its plans rather than
fund new projects with the residual or remaining
having to go to the equity or debt market to
profit distributed as dividends. If a company has
raise additional finance.
a profit of $100 million and is going to fund a
new development project costing $60 million,
Dividend policy is based on the answers
the remaining $40 million will be distributed
to several important questions. How much
as dividends. The calculations are slightly
dividend should a company distribute to
more complicated if the company wants to
shareholders? What will the impact of the
maintain its target debt-equity ratio. Using the
dividend policy be on the company’s share
same example, assume the target debt-equity
price? What will happen if the amount of
ratio is 0.5. If the whole $100 million is kept
dividend changes from year to year?
in the company as retained earnings, equity is
increased by $100 million. To maintain the target
Common dividend policies are the stable
debt-equity ratio, the company must borrow an
dividend policy, constant payout ratio and
additional $50 million. If there is a new project
residual dividend policy.
requiring $60 million, this sum is also funded
using the same debt-equity ratio. That is, the
In the stable dividend policy, management
company needs to raise $20 million debt and
maintains a fixed dividend per share each year.
$40 million equity. Since the profit is $100
The impact on share pricing can be seen from
million, the amount of dividend distributed is
the share valuation formula P0 = D1/(r-g) where
$60 million ($100 million - $40 million).
April 2009 T/Dialogue
Learning
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Investors prefer steady growth of dividends
HSBC. Before its announcement of its final
each year and avoid investment to companies
results for 2008, there were rumours that the
with fluctuating dividend policy. If you analyse
company would not be able to distribute the
the dividend per share of the shares in the above
same dividend as it did in 2007. Now, HSBC
table for the last 10 years, you will discover an
both reduced its dividend and announced rights
interesting pattern. Some companies reduced
issues. If a person usually distributes lai see of
their dividends during weak economic times
$20 and then suddenly increases it to $40, this
but others were still able to maintain the same
may imply that his finances are improving. If
dividend per share.
he drops the amount to $30 in the following
year, recipients may think that he has financial
Dividend theory includes an argument called
problems.
dividend irrelevance which was proposed by
two Noble Laureates, Modigliani and Miller.
To conclude, a company must not cut a positive
They argued that if a company distributed high
NPV project by paying dividends. Otherwise,
dividends now it may reduce its dividends
dividends cannot be maintained. It must not
later and thus the total effect is zero in time
reduce its dividend as this may imply there are
value. For example, a company may distribute
cash flow problems. A company should try to
a dividend of $1.1 per share and investors
pay dividends but at the same time maintain
may expect it can maintain this payment for
sufficient retained earnings to avoid having
some time. Eventually the company reduces
to raise new finance. A company must never
its dividend to $0.89 per share and the ultimate
allow the distribution of high dividend to be
time value result is the same.
funded by borrowing money and worsening
its debt-equity ratio. Finally, the company
A sudden increase in dividend may not be a
should set a target dividend payout ratio which
good sign. In an efficient market, investors are
is constructive but which also depends on the
able to distinguish between a genuine dividend
stability and prospects of the business.
increase and an artificial dividend increase.
Let’s consider an analogy, comparing the
distribution of dividends to the distribution
of lai see at Chinese New year. Distributing
$100 lai see does not mean that the person is
rich and can maintain these payments in the
future. Companies try to maintain a stable
dividend because if they reduce their dividend
payments, investors may suspect that company
has cash flow problem. This is the case for
T/Dialogue April 2009